essentials of fa_chapter 4

7/29/2019 Essentials of FA_Chapter 4

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Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

ESSENTIALSOF FINANCIAL

ACCOUNTING

BY ASISH K BHATTACHARYYASecond Edition

Chapter 4


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Profit or Loss for the Period

Equity = Assets Liabilities

Income increases equity and expenses reduce

equity. Equity also changes with fresh contribution

from equity participants (shareholders) and

distribution of profit to equity participants (dividend).

Therefore, increase (or decrease) in equity during

the accounting period, adjusted for change due to

contribution from or distribution of profit to equity

participants, represents profit (or loss) for theperiod.

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Equity, Net Income and Accounting Policy

Net profit (also called net income) depends on the

accounting policy of the company.

For example, Indian GAAP requires that the long-

term investment in equities issued by other entities

should be carried in the balance sheet at the

acquisition cost, while IFRS require that such

investments should be carried in the balance sheet

at fair value at the balance sheet date.

This difference in accounting principles results indifference in the measurement of equity and net

income in financial statements.

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IFRS and Indian GAAP

There are a few accounting principles and methodsstipulated in the Indian GAAP that differ from thosestipulated in the IFRS.

Entities domiciled in India are required to prepare and

present financial statements in accordance withprinciples and methods stipulated in the Indian GAAP.

India will adopt IFRS from 1 April, 2011. The adoptionwill be in stages.

In the first stage, companies with net worth of Rs. 1,000

crores and above will adopt IFRS. In addition companiesthat constitute SENSEX 30 or NIFTY 50 or which arelisted in any foreign stock exchange will apply IFRS.

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IFRS and Indian GAAP (cont.)

In due course, all companies except those unlisted

companies whose net worth is Rs. 500 crores will adopt

IFRS.

Thus, the Indian GAAP will converge with accounting

practices in more than 100 countries, which havealready adopted IFRS.

IFRS uses fair value measurement more extensively

than the Indian GAAP.

Use of fair value measurement brings volatility in thereported net profit because assets and liabilities are

restated at the fair value at the balance sheet date and

subject to a few exceptions, the change in the fair value

is reported in the profit and loss account.

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Net Profit or Loss and Other

Comprehensive Income

Both the Indian GAAP and IFRS do not permit

inclusion of a few items of income in arriving at the

profit or loss for the period covered by the profit and

loss account. IFRS require entities to present those items under

the heading othercomprehensive income

separately below the profit or loss for the period in

the profit and loss account. The amount by which the equity changed in the

current period is the total of the profit or loss for the

period and the other comprehensive income.

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Net Profit or Loss and Other

Comprehensive Income (cont.)

The Indian GAAP does not require presentation of

other comprehensive income in the profit and loss

account.

It requires those items to be presented directly in thebalance sheet as adjustments to equity.

Except for those items of income specified in

accounting standards, all items of income (including

gains) and expenses and losses are included inprofit or loss for the period.

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Revaluation Gain

Revaluation gain arising from the revaluation of an item offixed asset is not included in the profit or loss for the period inwhich the asset is revalued because that gain will not havecash consequence in the immediate future.

The gain will be realised either through use or disposal of the

asset. Therefore, the revaluation gain is transferred from revaluation

reserve, which is a part of capital reserve, to general reserve,which represents retained profit available for distribution toshareholders, on time proportion basis, over the remaininguseful life of the asset.

If the asset is disposed before the expiry of the useful life, thebalance in the revaluation reserve is transferred to profit orloss for the period in which the asset is disposed as a part ofprofit or loss on disposal.

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Revaluation Gain (cont.)

IFRS allow revaluation of fixed assets only if an

entity chooses to measure fixed assets at fair value.

Revaluation is not permitted if fixed assets are

measured at cost.

The Indian GAAP does not permit measurement of

fixed assets at fair value, but allows revaluation.

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Investment in Equity Shares: Changes in

Fair Value

Under IFRS, investments in equity shares issued by

another entity are measured at fair value.

The gain or loss arising from the change in the fair

value is recognised as profit or loss in the profit and

loss account for the period ended at the balance

sheet date.

However, if an investment is not held for trading, an

entity has to recognise such gain or loss in the

other comprehensive income.

Accumulated gain or loss is recognised in the profit and

loss account on disposal of the investment.

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Structure of Profit and Loss Account

Balance sheet presents the stock of assets and

liabilities, and also the amount of equity capital at

the end of the accounting period (balance sheet

date).

Profit and loss account summarises the incomes,

gains, expenses and losses for the current period.

It provides an understanding of the performance for the

current period and also provides an overview of how

equity has changed during the current period. Profit and loss account, in a way, presents the flow of

incomes, gains, expenses and losses for the current

year.

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Expenses

Expenses measure decreases in economic benefits

during the accounting period in the form of outflows

or depletions of assets or incurrence of liabilities

that result in decreases in equity, other than those

relating to distributions to equity participants.

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Expenses (cont.)

Expenses recognised in the income statement

represent one of the following:

a) Cost of goods sold, administrative expenses, selling

expenses, distribution expenses, income tax expenses

and financing charges.b) Expenditure incurred during the period from which no

asset could be recognised (e.g. research expenses);

and

c) Allocation of expenditure incurred during the period or

in any of the previous periods and recognised as an

asset during that period (e.g. depreciation of fixed

assets).

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Distribution to Equity Participants

Transactions with equity participants (equity share

holders) in their capacity as equity participantsdo

not result in either expense or income.

Therefore, distribution to equity participants is not

an expense.

For example, dividend is not an expense. Similarly, a

drawing by a sole proprietor is not an expense.

No gain or loss is recognised from a share buy-back

transaction.

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Discretionary Expenses

The expenditure that cannot be recognised as an asset

in the balance sheet is recognised as an expense in the

income statement irrespective of whether it has

contributed to the current operation.

Examples of these expenses are research and developmentexpenses, advertisement expenses, training expenses and

preventive repair expenses.

These expenses are called discretionary expenses,

because they do not have any inputoutput relationship

with revenue for the period.A firm may improve the operating profit for the current

period by reducing discretionary expenses.

But, that improvement in the current periods profit will reduce

the long-term earning power of the firm.

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Deferred Revenue Expenditure and

Fictitious Assets

The income statement approach to accounting permits

allocation of expenditure, which is not an asset, over

more than one reporting period if, the management

estimates that the expenditure will benefit more than

one accounting periods. Such expenditures are termed as deferred revenue

expenditure.

Examples of such expenditures are advertising expenditure to

launch a product, training expenditure other than expenditure

on regular training and expenditure on voluntary retirementscheme (VRS).

Sometimes, accountants use the term fictitious asset to

represent unallocated expenditure which is not an asset, but

is shown in the assets side of the balance sheet.

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Deferred Revenue Expenditure and

Fictitious Assets (cont.)

The contemporary accounting approach, which

focuses on the balance sheet, does not recognise

the concept ofdeferred revenue expenditure.

However, Indian companies treat preliminary

expenses and share issue expenses as deferred

revenue expenditure.

In order to calculate the net worth, balance of

deferred revenue expenditures presented in the

asset side of the balance sheet as miscellaneousexpenditure to the extent not written off is deducted

from the total of share capital and reserves and

surpluses.

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Preliminary Expenses

Preliminary expenses are incurred for the incorporationof a company. They may be paid by the promoters before the company is

incorporated or by the company after it is incorporated.

Since the expenditure is incurred and paid by the promoterseven before the company is incorporated, there is normally aclause that the promoters are reimbursed of all theexpenditure.

The Indian GAAP allows companies to treat preliminaryexpenses as deferred revenue expenditure and toamortise it over a reasonable period.

Indian companies usually adjust preliminary expenses againstshare premium.

IFRS require entities to recognise preliminary expensesin the profit or loss of the year in which the expenditureis incurred.

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Share Issue Expenses

An entity incurs various costs in issuing equity

shares.

Those costs might include registration and other

regulatory fees, amounts paid to legal, accounting and

other professional advisers, printing costs and stampduties.

The Indian GAAP allows entities to treat share

issue expenses as deferred revenue expenditure.

IFRS require share issue expenses to be deductedfrom equity.

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Income

Income measures increases in economic benefits

during the accounting period in the form of inflows

or enhancements of assets or decreases of

liabilities that result in increases in equity, other

than those relating to contributions from equityparticipants.

Increase in equity, other than due to contribution

from equity participants, is income.

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Transactions with Equity Participants

No income is recognised from a transaction with

equity participants (shareholders) in their capacity

as equity participant.

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Revenue

Revenue represents income from core (ordinary)

business of the entity.

For non-finance entities, revenue comes from sales of

goods or services, commission and government subsidy

on export and similar items. A finance entity earns revenue primarily from interest

and commission earned from variety of fund-based and

non-fund-based services being provided to constituents.

Non-finance entities record revenue at net of tradediscount, quantity discount and cash discount.

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Turnover

The term turnover is used interchangeably for

revenue for a particular period.

Turnover is defined in the UK Companies Act, 1985,

as the total revenue of an organisation derived from

the provision of goods and services, less trade

discounts, VAT, and any other taxes based on this

revenue.

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Turnover (cont.)

In the Guidance Note on Terms Usedin FinancialStatements issued by the Institute of Chartered

Accountants of Indiathe term sales turnover isdefined as:

the aggregate amount for which sales are effected orservices rendered by an enterprise.The term grossturnover and net turnover (or gross sales and netsales) are sometimes used to distinguish the salesaggregate before and after deduction of returns andtrade discounts.

The ratio of net sales to average carrying amount ofassets employed to generate the revenue is calledasset turnover ratio or simply asset turnover.

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Other Income

Income from activities other than those related to theordinary business of the entity (peripheral activities) isclassified as other income. For a non-financial entity, return on investment outside the

business (e.g. rent from investment property, interest or

dividend from investment in financial instruments such asbonds and shares issued by another entity) and income fromsale of assets other than stock-in-trade are classified as otherincome.

The term gain is often used to denote other incomesuch as income from sale of assets other than stock-in-trade.

An entity recognises other income and gains at the netamount, that is, at the gross amount less relatedexpenses.

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Short-Term Accruals

Short-term accruals are short-term timing differences

between income and cash flow.

These accruals create current assets and current

liabilities such as receivables, inventories, accrued

expenses, accrued income and pre-paid expenses. Short-term accruals record revenue when earned and

expense when incurred, and thus yield a number that

better reflects the result of the operation of the period

covered in the income statement.

Recognition of current assets and current liabilities in

the balance sheet provides useful information about the

financial condition of the reporting enterprise at the

balance sheet date.

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Long-Term Accruals

Long-term accruals arise from capitalisation.

Asset capitalisation is the process of deferring cost

incurred for the current period, whose benefits are

expected in future periods.

This process recognises long-term assets such asproperty, plant and equipment in the balance sheet and

allocates the cost of those assets over the periods,

which will benefit from their use.

This process improves the relevance of income byreducing its volatility, which arises in a cash flow basis of

accounting because investments in long-term assets are

often large and occur infrequently, and by matching

long-term investments to their benefits.

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PROFITAND LOSS ACCOUNT

STRUCTURE: INDIAN GAAPSchedule VI to the Companies Act,1956 provides rules for thepresentation of profit and loss account. It does not provide anyformat for profit and loss account. Accounting Standard (AS)5, NetProfit or Loss for the Period, Prior Period Items and Changes inAccounting Policies, stipulates principles for the preparation ofprofit and loss account.

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Schedule VI Requirements

Schedule VI of the Companies Act, 1956 provides an

exhaustive list of disclosures required in the profit and

loss account.

The following are the important disclosures required by

the schedule VI:I. Every material feature including non-recurring transactions

or transactions of an exceptional nature

II. The turnover, that is, the aggregate amount of sales

III. The value of raw materials consumed

IV. The opening and closing stock of goods produced/finishedgoods purchased

V. The gross income derived from services rendered

VI. The amount provided for depreciation, renewals or

diminution in value of fixed assets

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Schedule VI Requirements (cont.)

(vii) Interest expense(viii) Income tax expense

(ix) Expenditure incurred for each of the following itemsseparately: consumption of stores and spare parts

power and fuel

rent repair to buildings

repairs to machinery

salaries wages and bonus, contribution to provident and otherfunds, workmen and staff welfare expenses

insurance

rates and taxes miscellaneous expenses, provided that any item under which the

expenses exceed 1% of the total revenue of the company or Rs.5,000, whichever is higher, should be presented as a separateand distinct item

(x) Income from investments and

(xi) Miscellaneous income

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AS-5 Requirements

The following are the important principles stipulated

in AS-5:

a) Profit or loss from ordinary activities and extraordinary

items should be disclosed separately and

b) When items of income and expenses within profit or lossfrom ordinary activities are of size, nature, or incidence

that theirdisclosure is relevant to explain the performance

of the enterprise for the period, the nature and amount of

such items should be disclosed separately.

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Extraordinary Items

Extraordinary items are incomes or expenses that

arise from events or transactions that are clearly

distinct from ordinary activities of the firm and,

therefore, are not expected to recur frequently or

regularly. Extraordinary items are identified by the nature of the

transaction or event in relation to the business ordinarily

carried on by the enterprise rather than by the

frequency with which such events are expected to

occur.

IFRS do not recognise the concept of extraordinary

item.

However, US GAAP recognises the same.

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Essentials of Financial AccountingAshish Bhattacharya

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Hindustan Unilever Limited (HUL)Exception and Extraordinary Items in the Profit and Loss

Account for the 18 months period ended on 31 March, 2009


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Hindustan Unilever Limited (HUL)Profit and Loss Account for the 15 months period ended on

31 March 2009


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Fringe Benefit Tax

The Fringe Benefit Tax (FBT) was introduced by the

government in the year 2005 on expenses incurred

by employers towards entertainment, festival

celebrations, gift, use of club facilities, provision of

hospitality, maintenance of guest houses,conferences, employee welfare, use of health club,

maintenance of motor cars, telephone, sales

promotion and publicity, etc.

Under the current dispensation, an employer has topay FBT at 30% on the fringe benefit, the taxable

value of which is determined in accordance with a

formula.

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Earnings Per Share

Although there are lot of limitations, earnings per share

(EPS) is a widely used measure of the performance of

the enterprise.

Therefore, companies are required to present EPS as a

note below the profit and loss account. Basic EPS is calculated by dividing the net profit

(reduced by the dividend payable to preference share

holders), which is attributable to equity shareholders, by

weighted average number of shares for the period.

For example, if the number of outstanding shares at the

beginning of the year was 100 and 100 shares were issued at

the end of six months of the current period, the weighted

average number of shares for the current period is 150

(100 + 100 0.50).

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Earnings Per Share (cont.)

Dilutionis a reduction in earnings per share or an

increase in loss per share resulting from the

assumption that convertible instruments (e.g.

convertible debentures) are converted, that options

or warrants are exercised, or that ordinary sharesare issued upon the satisfaction of specified

conditions.

Diluted EPS is calculated with the assumption that

all potential equity shares, conversion of which willresult in the dilution of EPS, will be converted into

equity shares.

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Hindustan Unilever Limited (HUL)Profit and Loss Account for the 15, month period ended

on 31 March, 2009


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Sales and Excise Duty

The amount of sales recognised in profit and lossaccount includes export incentives.

The amount of excise duty included in sales is deductedto determine the amount to be recognised in the profitand loss account.

Excise duty is an indirect tax levied and collected on goodsmanufactured in India.

Generally, manufacturer of goods is responsible to pay theduty to the government.

It is collected on dispatch of the goods or on internalconsumption.

The amount of sales recognised in the profit and loss accountis net of excise duty.

Often the term gross sales is used to denote salesvalue including the amount of excise duty and the termnet sales is used to denote sales value net of exciseduty.

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Interest and Dividend Income

As required by the Companies Act, 1956, income

from trade and non-trade investments has been

presented separately.

Trade investments are those from which the

company expects trade benefits, in addition toregular return and capital gain.

Examples of trade investments are investments in

vendor companies and investment in associates.

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Schedule VI: Proposed Change

The government has proposed a change in

Schedule VI to the Companies Act, 1956. The

proposed revised Schedule VI will require a

company to present the profit and loss account in a

new format.

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Particulars Amount

I Revenues from operations

II Cost of sales/services

III Gross profit (III)

IV Operating expenses:(1) Selling and marketing expenses(2) Administrative expenses

Total operating expense

V Results from operating activities (IIIIV)

VI Non-operating income/expenses:(1) Gains/(losses) on sale of long-term investments

(2) Foreign currency exchangegains/(losses), net(3) Finance cost

(4) Other income(5) Other expenses

Total Non-operating income/expenses:

VII Income before income tax (V + VI)

VIII Tax expense:

(1) Current income tax(2) Deferred income tax(3) Others

IX Profit for the period (VIVII)

X Earnings per equity share:(1) Basic(2) Diluted


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PROFITAND LOSS ACCOUNT: IFRS

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Statement of Comprehensive Income

(Profit and Loss Account)

At a minimum, the statement of comprehensive

income should include line items that present the

following amounts for the period:

a) Revenue

b) Finance costs

c) Share of profit or loss of associates and joint ventures

accounted for using the equity method

d) Tax expense

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Statement of Comprehensive Income

(Profit and Loss Account) (cont.)

e) A single amount comprising the total of: the post-tax

profit or loss of discontinued operations; and the post-

tax gain or loss recognised on the measurement to fair

value less costs to sell or on disposal of the assets or

disposal group(s) constituting the discontinued

operation

f) Profit or loss

g) Each component of other comprehensive income

classified by nature (excluding amount in (h)

h) Share of other comprehensive income of associatesand joint ventures accounted for using the equity

method

i) Total comprehensive income.

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Disposal Group and Discontinued

Operation

Discontinued operationrepresents a component of thecompany that either has been disposed of or isclassified as held for sale. The component represents a separate line of business or

geographical area of operation which the entity has disposedof or has decided to dispose of as a part of single coordinated

plan. Disposal group refers to a group of assets to be

disposed of by sale or otherwise, together as a group ofsingle transaction, and liabilities directly associated withthose assets that will be transferred in the transaction. For example, if a conglomerate engaged in variety of

businesses has decided to dispose one of its businesses (e.g.manufacturing of leather accessories) and has put it on block,the assets and liabilities of that business form the disposalgroup.

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Disposal Group and Discontinued

Operation (cont.)

Non-current assets of a disposal group or

discontinued operation are measured at lower of

cost or fair value less costs to sell.

Cost represents the carrying amount determined using

the normal rules immediately before classifying thebusiness or geographical location as a disposal group.

No depreciation is charged on non-current assets of a

disposal group.

Change in fair value less cost to sell represents gain or

loss.

The gain or loss is included in profit or loss for the period.

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IAS-1 Principles

An entity should recognise all items of income and

expense in a period in profit or loss unless an IFRS

requires or permits otherwise.

When the items of income or expense are material,

an entity should disclose it nature and amountseparately.

An entity should present an analysis of expenses

using a classification based on either its nature or

its function.An entity classifying expenses by function shall

disclose additional information on the nature of

expenses.

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IAS-1 Principles (cont.)

Example of functional classification

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207 206Revenue 390,000 355,000Cost of sales (245,000) (230,000)

Gross profit 145,000 125,000

Other income 20,667 11,300Distribution costs (9,000) (8,700)Administrative expenses (20,000) (21,000)Other expenses (2,100) (1,200)

Finance costs (8,000) (7,500)Share of profit of associates 35,100 30,100

Profit before tax 161,667 128,000

Income tax expense (40,417) (32,000)Profit for the year from continuing operation 121, 250 96,000Loss for the year from discontinued operation (30,500)Profit for the year 121,250 96,000


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Cost of Sales

Cost of sales is the total of costs incurred to

manufacture (including depreciation on depreciable

assets engaged in manufacturing activities) or

purchase the goods and to bring it to the location

and condition of sale. Thus, cost of sales does not include operating

expenses and distribution costs.

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PROFIT HIERARCHY

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Financial Ratio Analysis

Absolute numbers in financial statements fail to

provide interesting insights into the performance of

the company.

Therefore, analysts have developed tools to

analyse financial statements.

The most commonly used tool is the ratio analysis.

Ratios of related numbers in financial statements

provide historical insight into the financial position

and performance of an entity.

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Financial Ratio Analysis

Analysts compare the financial ratios of an entity for

a number of past years in search of a pattern of

past performance.

A pattern of past performance helps forecast future.

However, financial ratios is one of the inputs in

forecasting future.

Analysts also compare ratios of different

comparable entities to analyse relative

performance.

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Gross Profit

Gross profitis the difference between revenue and

cost of goods sold.

Cost of goods soldis the cost of manufacturing or

procurement of finished goods sold.

It includes expenses incurred to bring the goods to the

location and condition of sale, but does not include

expenses relating to activities performed after the goods

are placed in the warehouse.

Analysts calculate gross profit ratio to measure theefficiency and effectiveness of manufacturing and

procurement activities.

The ratio is calculated by dividing gross profit by net

sales, which is the amount of sales less excise duty.

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Earnings Before Interest Tax Depreciation and

Amortisation (EBITDA)

EBITDA is often called cash margin.

Depreciation and amortisation are considered non-cash

expenses.

EBITDA is the amount of margin over cash

operating expenses, including the cost of goodssold.

The ratio of EBITDA to sales ratio is called cash

margin to sales ratio.

It measures margin over cash manufacturing andoperating expenses.

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Earnings Before Interest Tax Depreciation and

Amortisation (EBITDA) (cont.)

It is a good measure of margin for businesses

operating in capital intensive industries in which

initial investment in infrastructure is very high while

subsequent investments in fixed assets are

relatively small (e.g. telecommunication industry). The ratio also helps compare the margin of different

companies in the same industry.

Depreciation and amortisation depends on investment in

fixed asset. Investment in fixed assets to create the same capacity

in different points in time, might be different.

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Earnings Before Interest and Tax (EBIT)

Earnings before interest and tax (EBIT) is

calculated by deducting depreciation and

amortization from EBITDA.

EBIT is often called operating profit.

To be precise, EBIT represents operating profit only if,other income does not include non-operating income.

Non-operating income is income from non-

operating assets, which do not contribute to the

operations of the enterprise. An example of non-operating assets is investment in

investment property. Therefore, rent from investment

property is a non-operating income.

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Earnings Before Interest and Tax (EBIT)

(cont.)

Exceptional items should be excluded from EBIT to

calculate the ratio.

EBIT to sales ratio is used to measure the operating

marginearned by an entity engaged in a

commercial venture.

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Net Profit

Profit or loss for the period (often referred as net

profit) is a single numberthat is widely used as a

bench mark to measure the performance of an

entity.

It is calculated by deducting tax expenses andfinance cost from EBIT.

This is the amount of operating surplus that belongs

to shareholders after paying the governments

share (income tax) and debt holders share (financecost).

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Net Profit (cont.)

Preference dividend is deducted from the net profit

to calculate the profit attributable to equity

shareholders.

Subject to legal provisions regarding distribution of

profit, the profit attributable to equity shareholdersis available for distribution as dividend.

Decision on what part of the available profit should

be distributed is a part ofoverall financing decision.

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P/ERatio

Fair measurement of net profit is important because

it is used on the denominator to calculate the P/E

ratio.

It is the most common measure of how expensive a

stock is.

It is equal to a stocks market capitalization divided

by its after-tax earnings over a twelve-month

period, usually the trailing period but occasionally

the current or forward period.

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P/ERatio (cont.)

The value is the same whether the calculation isdone for the whole company or on a per-share basis.

The higher the P/Eratio, the more the market is

willing to pay for each rupee of annual earnings.

The last year's price/earnings ratio (P/Eratio) would

be actual, while current year and forward year

price/earnings ratio (P/Eratio) would be estimates,

but in each case, the P in the equation is the

current price. Companies that are not currently profitable (that is, ones

which have negative earnings) do not have a P/Eratio at

all.

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Comprehensive Income

Comprehensive income is calculated by adding othercomprehensive income to the amount of profit or loss

for the period.

Comprehensive income represents the amount by

which the equity has changed during the currentperiod, other than changes arising from transactions

with equity participants (shareholders).

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OPERATING RATIOS

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Operating Ratios

In most industries operating expenses are drivenby revenue.

Therefore, it is quite logical to assume that there is

a correlation between revenue for the period and

each item of expense recognised in the profit andloss account.

Analysts calculate the ratio of each item of expense

to net sale to capture the effectiveness in using in

different types of resources or services. Operating ratios are also used as inputs to forecast

future performance.

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Operating Ratios (cont.)

Discretionary expenses have no cause and effectrelationship with the revenue recognised for the

period.

However, ratio of an item of discretionary expense

to net sale provides an insight into whether theentity has cut the discretionary expense to present

better performance than what it really is.

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O ti R ti Hi d t U il


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Operating Ratios: Hindustan Unilever

Limited (HUL)

Data from annual reports

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Particulars 2008-2009

(15 months)

2007

(12 months)

Sales 2,023,933 1,367,543

Material consumed and

purchase of goods

1,125,948 741,295

Employee compensation 115,212 76,781

Processing charges 21,040 13,614

Consumption of stores and

spare parts

12,056 8,752

Repairs and maintenance 11,080 8,893

Power, light, fuel and water 30,137 19,889

Rent 17,188 12,053

Advertising and sales

promotion

213,092 144,022

Carriage and freight 113,668 73,141


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Operating Ratios: HUL (cont.)

Operation ratios

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2008-2009

(15 months)

2007

(12 months)

Material consumed and

purchase of goods/sales

55.63% 54.21%

Employee compensation/sales 5.69% 5.61%

Processing charges/sales 1.04% 1.00%

Consumption of stores and

spare parts/sales

0.60% 0.64%

Repairs and maintenance/sales 0.55% 0.65%

Power, light, fuel and

water/sales

1.49% 1.45%

Rent/sales 0.85% 0.88%Advertising and sales

promotion/sales

10.53% 10.53%

Carriage and freight/sales 5.62% 5.35%


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Operating Ratios: HUL (cont.)

Notes:

i. In the denominator, we have not included other income

because other income does not create any significant

demand on operating activities and does not create any

demand on material.ii. Comparison of ratios for two years is not sufficient to

understand the relationship between expenses and sales,

and to capture the pattern of change in that relationship, if

any.

iii. Actual ratios should be compared with bench mark ratiosto evaluate the performance.

iv. Financial analysts compare financial ratios of comparable

companies to assess relative performance.

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PROFITABILITY RATIOS

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Profitability Ratio

Profitabilityis the rate (per annum) at which profit isgenerated.

It is expressed as profit per unit of input.

Profitability is usually presented as a percentage such

as return on investment. The ratio is calculated by taking a measure of profit in

the numerator and a measure of input in the

denominator.

Usually, EBIT or net operating profit less adjustedtax (NOPLAT) is used in the numerator and

invested capital, capital employed or total asset is

used in the denominator.

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Essentials of Financial Accounting, Second Edition

ASISH K. BHATTACHARYYA

Profitability Ratio (cont.)

The limitation of profitability is that it focuses onprofit and ignores quality.

Profitability has severe limitations as a measure for

decision making.

For example, profit cannot be managed directlybecause it is remote from value creation activities.

Similarly, it fails to provide any insight into the business

dynamics.

However, the greatest advantage is that once theinput is well defined, it is easily understood by all

who are concerned with the performance of an

entity engaged in commercial ventures.

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Annualisation

To calculate a ratio we use one number from theprofit and loss account, and another number from

the balance sheet.

The number from the profit and loss account should

be annualised if the period covered by the profitand loss account is shorter or longer than twelve

months.

The annualized number is calculated by multiplying

average per month figure by 12. We use annualised profit in the numerator to calculate

the profitability of an entity for a specified period.

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Net Operating Profit Less Adj sted Ta


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Net Operating Profit Less Adjusted Tax

(NOPLAT)

NOPLAT is a profit measure that is not affected bythe capital structure of the entity.

EBIT is also not affected by the capital structure of

the entity.

The difference between the two profit measures isthat NOPLAT is profit before interest but after

income tax expense and EBIT is before interest and

tax.

NOPLAT is calculated using the following formula: NOPLAT = Net Profit Exceptional Income

(1 Tax Rate) + Interest Expense (1 Tax Rate)

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Profitability

Profitabilityis calculated taking any of the followingthree measure of investment as input: invested

capital, capital employed, and total asset.

Return on invested capital=

(EBIT/Invested Capital) or (NOPLAT/Invested Capital)

Return on capital employed=

(EBIT/Capital Employed) or (EBIT/Capital Employed)

Return on total asset=

(EBIT/Total Asset) or (EBIT/ Total Asset)

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Profitability (cont.)

Invested capital is the total of equity and debt in thebalance sheet.

Capital employed is the total of equity and long

term debt in the balance sheet.

Therefore, we should use Earnings before long-terminterest and taxin the numerator to calculate return on

capital employed.

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essentials of fa_chapter 4

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